Stephen Bainbridge's Journal of Law, Religion, Politics, and Culture

12/16/2015

Is hedge fund activism sustainable?

Hadiye Aslan and Praveen Kumar's analysis of industry-wide effects of hedge fund activism ends with an interesting conclusion about the long-term sustainability of the phenomenon:

The analysis of the product market effects of HFA also generates some interesting hypotheses on the future of activist investor intervention. If firms become more efficient through pro-active responses to the threat of intervention, and if the number of activist investors keeps increasing, then the returns to HFA should come down over time. Furthermore, there can be a backlash to HFA from a variety of directions. Access to hedge funds is limited because the average individual investor does not have the financial wherewithal to invest in them. If HFA reduces the returns of the competitors to HFA targets (as shown by our analysis), then HFA is likely to adversely affect average investors, who are more likely to hold equity in the competitors than the target. That is, HFA is not a positive-sum game in terms of generating higher equity returns for all investors. In that case, there will be increasing pressure on mutual and pension funds (which is how most individual investors participate in stock markets) to put pressure on the management of firms they own. In this case, again, activist investors could lose their edge in return performance and could even become redundant.

Is this likely to result in industry-wide improvements? They also suggest some reasons to doubt it:

... we do not find support for the view that activist investors have industry-wide benefits, for example, through the introduction of best practices that are emulated by industry firms. Indeed, our analysis indicates that the post-HFA economic pressure on industry competitors lowers their capital investment and productivity on average, which may hasten the exit of weaker peers from the industry. And in ongoing research, we find that target firms improve profits by extracting price concessions from their suppliers. Of course, exit by economically inefficient firms is central to a dynamically efficient economy. Consistent with this, we find that the threat of activist investor intervention remains a potent incentive for firms to make pro-active improvements; such firms are generally able to compete effectively with target firms. Nevertheless, we have little knowledge today of long run economic effects of HFA on industry competition and innovation. For example, if HFA encourages “industry consolidation,” such as seen recently in the pharmaceutical industry, then there may be long run detrimental effects on R&D investment and innovation. In light of the positive industry- and economy-level externalities of R&D spending, such reductions in corporate research spending could have long run negative consequences for an economy built on continuous technological advancement. In a similar vein, there may be social costs from reduced employment if the pressured competitors and suppliers of HFA target firms are forced to lay off workers.

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Hadiye Aslan and Praveen Kumar's analysis of industry-wide effects of hedge fund activism ends with an interesting conclusion about the long-term sustainability of the phenomenon:

The analysis of the product market effects of HFA also generates some interesting hypotheses on the future of activist investor intervention. If firms become more efficient through pro-active responses to the threat of intervention, and if the number of activist investors keeps increasing, then the returns to HFA should come down over time. Furthermore, there can be a backlash to HFA from a variety of directions. Access to hedge funds is limited because the average individual investor does not have the financial wherewithal to invest in them. If HFA reduces the returns of the competitors to HFA targets (as shown by our analysis), then HFA is likely to adversely affect average investors, who are more likely to hold equity in the competitors than the target. That is, HFA is not a positive-sum game in terms of generating higher equity returns for all investors. In that case, there will be increasing pressure on mutual and pension funds (which is how most individual investors participate in stock markets) to put pressure on the management of firms they own. In this case, again, activist investors could lose their edge in return performance and could even become redundant.

Is this likely to result in industry-wide improvements? They also suggest some reasons to doubt it:

... we do not find support for the view that activist investors have industry-wide benefits, for example, through the introduction of best practices that are emulated by industry firms. Indeed, our analysis indicates that the post-HFA economic pressure on industry competitors lowers their capital investment and productivity on average, which may hasten the exit of weaker peers from the industry. And in ongoing research, we find that target firms improve profits by extracting price concessions from their suppliers. Of course, exit by economically inefficient firms is central to a dynamically efficient economy. Consistent with this, we find that the threat of activist investor intervention remains a potent incentive for firms to make pro-active improvements; such firms are generally able to compete effectively with target firms. Nevertheless, we have little knowledge today of long run economic effects of HFA on industry competition and innovation. For example, if HFA encourages “industry consolidation,” such as seen recently in the pharmaceutical industry, then there may be long run detrimental effects on R&D investment and innovation. In light of the positive industry- and economy-level externalities of R&D spending, such reductions in corporate research spending could have long run negative consequences for an economy built on continuous technological advancement. In a similar vein, there may be social costs from reduced employment if the pressured competitors and suppliers of HFA target firms are forced to lay off workers.